Know the 5 Cs of credit before applying for a loan

Woman signing loan papers

Before you apply for your next home or car loan, it’s best to know what you look like in the eyes of a lender first. The five characteristics of credit — character, capital, capacity, collateral and conditions — tell lenders how likely you are to repay a loan. Knowing where you stand could mean the difference between getting what you want or getting nothing at all.

Character

Information from your credit report, such as your credit score and borrowing history, is weighed against more personal traits (e.g. honesty and integrity) that are harder to attach a number to. Lenders use these details to form an opinion of your ability and willingness to repay your debt.

Know what’s on your credit report. Each year you can get one copy of your credit report from the three reporting agencies at annualcreditreport.com. Or you can order one free copy of your report directly from Equifax, TransUnion and Experian if you prefer. Clean up errors or outstanding debts to help boost your credit rating and, likely, your position with the lender. 

Capital

A lender wants to know you’ll still have extra capital or money to live on if you take on a loan payment. This is where your net worth — the value of your assets (e.g. car, real estate, cash and investments) minus liabilities like debt — becomes important. A higher net worth suggests you can handle the extra debt. If your number is low, start cutting expenses. Use the spare cash to boost your savings and your standing.

Capacity

Your past and present debt obligations are weighed against your income as an indicator of whether you’re able to make payments. It’s a good idea to keep your debt-to-income ratio under 43 percent to show you can repay your debts. To calculate your debt-to-income ratio, add up all your monthly debt payments. Then divide that number by your gross monthly income. For example, if your monthly debt payments are $2,000 and your gross monthly income is $6,000, then your debt-to-income ratio is 33 percent. ($2,000 is 33 percent of $6,000.)

Collateral

Lenders may need more than your word to ensure repayment. They’re going to want collateral. With a new auto loan, for instance, the car title is held as collateral until you’ve paid off the loan.

If your credit score is low, some may even ask for a co-signer, such as a family member, who agrees to take full responsibility for the loan if you don’t pay. If you default on the loan, both of you will get a negative mark on your credit reports. So be sure you’re able to make the payments if you add a co-signer. Otherwise, you could ruin a personal relationship.

Conditions

The financial health of your employer or the market conditions of the local economy could also play a role in getting your loan approved. Lenders may wonder how likely you are to lose your job and become unable to repay your debt.

Conditions could also refer to loan terms (e.g. 15- or 30-year Adjustable Rate Mortgage (ARM)), purpose, interest rate and payment schedule, for example.

Use the five Cs to put yourself in a better financial position before applying for your next loan.

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